The DC correlation conundrum

Over the past decade, pension schemes in all shapes have been cranking up allocations to illiquid assets. UK DC schemes have been relatively slower to venture into the illiquid space, evidenced by a survey commissioned by the Department for Work and Pensions which found two-thirds of DC schemes do not currently invest in illiquid assets.

Yet, with long-term investment horizons, DC schemes are well placed to harness any potential illiquidity premium on offer. The government, Financial Conduct Authority and Bank of England have been working in concert over the past year to pave the way into illiquid assets for DC investors. The Productive Finance Working Group recently published a series of guides designed to enhance trustees’ knowledge and understanding of illiquid vehicles. It is also now a requirement for scheme trustees to include a formal policy on illiquid investments in their chairperson’s statement.

The scene is set for a weighty increase to illiquid assets – but what are the potential pitfalls, and how should DC schemes adjust portfolios to optimise their risk-adjusted returns while being mindful of their resilience?

Recent ructions in the UK gilt market exposed the soft underbelly of many UK defined benefit (DB) pension schemes. As these schemes scrambled to meet cash liabilities, liquidity fast became the crux of the issue.

These schemes were forced into selling what they could, rather than what they wanted to. Those with large exposure to illiquid investments were especially distressed. Illiquid investments, by their nature, are difficult to exit in a hurry.

While UK DC schemes have no need for LDI, an increase in illiquidity can reduce scheme flexibility. Illiquid assets typically have lumpy cashflows both in and out. It so happens that illiquid strategies capital requirements tend to coincide with weakness in equity markets – again, potentially forcing investors’ hands into selling assets at inopportune moments. And with persistent inflation, a meaningful long-term cash float to fund future commitments will drag on real returns.

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If there is an influx into illiquid investments across DC schemes, portfolios may begin to resemble something akin to a barbell: a heavy weighting to listed equites and bonds at one end; and illiquid (typically private) assets at the other. The inherent risk with this portfolio is that in an environment of volatile bond yields and inflation, both ends of the barbell fall together. Viable if the scheme can ride it out, not viable if it is forced into crystallising the falls.

The chart above shows how in September 2022, bonds, equities and illiquid assets (in this case private equity) fell in tandem. This is the correlation conundrum.

The key is in balancing the ends of the barbell with an uncorrelated strategy – one that offers material downside and inflation protection, and crucially, liquidity throughout market cycles – serving to improve risk-adjusted returns combined with resilience and flexibility.